Option Trading Basics
Option Premium: OK, so why do option writers go to all the trouble and risk of writing options, and holders go to all the trouble of buying something which could expire worthless. The answer is the magical word PREMIUM. In online option trading it is premium that makes the world go round – it is the reason we do it as traders and speculators, rather than investors ( which I will cover shortly). So let’s consider the option premium, what it is, and the forces at work which dictate the values listed on the online trading exchanges.
Online Option Trading : The Premium
When you buy an option the price you pay is called the premium, and when you sell an option, the premium is the amount you receive. This premium, changes constantly every second, and every minute of every day and is a reflection of the market forces as buyers and sellers compete, coupled with the performance of the underlying asset. Now, there are many factors which affect the value of the option which we will look at in a minute, but one thing needs to be made clear at this point as follows:
- As an option seller you ALWAYS keep the premium, no matter what happens to the option.
- As an option buyer, you NEVER receive any of the premium back whatever happens to the option.
It is the premium that you will see quoted on the exchanges, and just like shares and stocks these prices change continuously throughout the day. Whether a stock or share is listed as an option is decided by the option exchange as they only want to list options that will be widely traded in order to provide a liquid market. Finally, as an option writer, you will never ever know who holds your contract, which may have been bought and sold many times over, in the course of its short life! Let me try to give a simple example which I hope will make the point more clearly.
Imagine you have decided to buy a classic car . You find a nice example locally and agree a price with the seller. You do not have the funds available for the next four weeks, but ask the seller if he would kindly hold the car for you at that price and sell it to you in four weeks time. The seller agrees but asks in return for a ‘premium’ for keeping the car in storage for you, which he will keep even if you decide not to go ahead and pay for the car. You agree and pay him his premium, and you now have an ‘option’ to buy. In the next four weeks you collect enough money to pay for the car and buy it at the agreed price and the option contract has been completed.
Now supposing during the four week period, the original factory where the cars were made and maintained is destroyed by fire. The car has now become even more collectable and second-hand values soar. However, you have agreed a contract price with the seller and as a result you are now able to profit from this position. You can either buy the car at the agreed price, knowing it is now worth much more, or alternatively sell your contract to someone else, who may be gambling that prices of the car may go higher still, or who may actually want to buy the car anyway. The owner of the car has no choice – he has to fulfil the contract obligations if asked to by the holder of the option contract. His only other alternative ( if he still wants to keep the car ) is to buy the contract back from you ( or whoever is holding it ) which will of course cost him more than the original premium he received from you. In other words the option premium has increased in value, since the underlying asset ( the car ) has also increased and therefore made the option contract more valuable.